Economic Update: 20 October 2017

Economic Update: 20 October 2017

The Investment Management team round-up some of this week’s news.

Inflation

This week, Bank of England (BoE) officials have been questioned by the UK Parliament Treasury Committee. Their grilling is hot on the heels of indications that central bank committee members are edging towards marginally increasing interest rates in the near future, possibly as early as next month.

In the report presented by the BoE during the testimony, the trend in UK inflation was shown to be upward and reaching 3%, one percent higher than the BoE target and the highest level in the last five years. The report highlights that overall price growth has been driven by increasing food and transportation costs.

Governor Mark Carney expressed BoE views that inflation is more likely to increase than decrease in the near future and added that general price levels are still being impacted by the post-Brexit devaluation of the pound making the cost of purchasing imported goods more expensive. The inference is that sterling’s devaluation effects will be present for up to three years from the referendum result announced on 23rd June 2016.

The recently announced inflation figures squeeze household income even harder as wage growth slowed to 2.1% growth over the year for August from the 2.2% a month before.

UK Household Income Squeeze

Source: Bloomberg, data as of 30 September 2017

The case for an interest rate hike is stronger now than at any point in the last 10 years but many believe the act of raising rates will be symbolic rather than having any meaningful role associated with controlling inflation within the economy.

The probability that the Monetary Policy Committee (MPC) will raise rates to 0.5% in November is measured at 81.8%.  Therefore, if rates are raised, we can assume it is largely discounted by professional investment managers in what is a repeat pattern where central banks signal their intentions in advance. This is evident in the US where 3 small rate rises have taken place since December 2015 without causing any significant upset.

UK Interest Rate Hike Probability in November’s Meeting

Source: Bloomberg, data as of 19 October 2017

Mark Carney also touched on Brexit contingency planning, mentioning that a ‘hard’ exit scenario is on their radar. However, he pointed out that a smooth transition is in both sides’ interests and that he expects the UK and EU ultimately to reach a deal. He noted that despite businesses being a bit pessimistic on the likelihood of a ‘soft’ Brexit deal happening, consumer confidence has remained relatively stable.

In conclusion, the testimony supported previous views from the Bank of England that a marginal interest rate rise is feasible and that quantitative tightening, i.e. reversing the process of quantitative easing (QE), will not begin until officials are comfortable that cutting the asset buying programme associated with QE will not damage future growth.

China

The Chinese Communist Party Congress kicked-off on Wednesday with President’s Xi Jinping’s speech. Even for his most ardent followers it was hard to concentrate for the entire 3.5 hours that this lasted!  Officials looked at their watches and yawned as the President delivered his address. Leaving aside the duration of this marathon of a speech, the once-in-five-years congress revealed some big ambitions for the second largest economy in the world.

Echoing famous Chinese president Mao Zedong, President Xi declared that “the Chinese nation now stands tall and firm in the east”. The importance of strong state-owned enterprises (often referred to as SOE’s) and market mechanisms were emphasised as drivers of the economy. More openness has been promised offering better prospects for foreign companies.

Even though many economic and financial reforms proposed four years ago were not delivered, the economy has performed very well. The latest figures show that Gross Domestic Product (GDP) grew 6.8% in the year to the end of September 2017 and the economy should hit the 6.5% full year target. However, some economists are concerned that the rate of economic growth is unsustainable. They worry that massive injections of monetary and fiscal stimulus in 2016 has pushed up debt levels, creating risks that could undermine long term growth.

Other economic indicators continue to show that healthy growth, albeit at a slower pace is now anticipated as the current cycle matures. This is to be expected as the effects of prior stimuli wane, and President Xi did not mention any long-term economic growth targets.  Analysts interpret this as signs of a cautious Chinese government accepting the inevitability that the current pace of economic development will slow.

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